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Why Are Stocks Still Rising? Is This A Bubble?

Investors often ask me, “why is the stock market still going up after five years?” They think it must mean ‘prosperity is ahead.’ Actually, it’s largely due to financial engineering: stock buybacks.

It’s important to see who has been doing the big buying. The only big buyers of stocks over the past five years are the Sovereign Wealth Funds of countries and corporations buying back their own stocks (buybacks). The amount is well over $1 trillion per year. Every other traditional large buyer category has been a net seller for the past five years.

Many of the companies, like IBMIBM and AppleApple, have borrowed billions of dollars to buy their stock. Apple just completed a $60 billion buyback and has now increased the new buyback program to $90 billion. It is borrowing part of the money to do this.

Such huge buybacks have never been done before in history. Instead of using the money for developing new products, or buying companies thta are complementary, they buy their own stock certificates. That’s not the path to sustainable growth.

Money is very cheap, so why not borrow? Well, money may not stay cheap. When short-term rates have their first upward spike, equity capital will become cheaper than debt. And that’s when buybacks stop and thus the support for the stock market.

The bulls will argue that these companies have billions of dollars overseas and that therefore, the debt is not a burden. They don’t bring it back home for tax reasons. But when rates rise, the cost of debt rises faster than the money market return of the cash overseas.

Buybacks do nothing for the value of a company. It just reduces the number of shares outstanding. It’s a financial maneuver to increase the “earnings per share” in order to boost the stock price. That makes the stock options of management more valuable. It often hides the fact that total company earnings are not rising and may even be declining. But naive stock buyers don’t realize this.

In the first quarter of 2014, stock buybacks among the S&P 500 companies increased 59% from the same quarter a year ago, totaling $159.3 billion. This amount was exceeded only by the amount of stock buybacks in the third quarter of 2007, the top of the market before the financial crisis.

By one estimate, stock buybacks boosted earnings per share by 4% or more on 99 companies in the S&P 500, simply by lowering the number of shares outstanding.

The leader of the pack was Apple, which spent $18 billion on its own shares, cutting its shares outstanding by 7.1%. That increased earnings per share by 15.2%.

By the way, Apple CEO Tim Cook has surprised me since he had dinner and meetings with financial genius and corporate raider Carl Icahn. These meetings occurred before April 23 when Apple announced its big financial engineering program. It announced record stock buybacks of Apple stock, a big 7 to 1 stock split, an increase in dividends, etc. It appears he learned a lot from Mr. Icahn about financial engineering and how to get the stock price up. Icahn owns more than seven million shares of Apple.

IBM is another big buyer of its own stock. It’s sales are about the same as six years ago. There is no increase in capital investment. Money has gone into buybacks. Is that what makes a successful firm?

Some investors worry and ask, is the stock market in a bubble? Wall Street analysts always talk about the P/E ratio of the S&P 500 index being at 17, which they say is “fair value.” But it’s only fair value if the earnings don’t decline. Once the financial engineering stops, and a recession threatens, the 17 P/E is no longer “fair value.”

Furthermore, if we look away from the S&P 500, and look at the Russell 2000 small cap index, we see a P/E ratio of 84. That’s astonishing. You never hear analysts saying that in the media. It seems to be prohibited because it could scare investors away. This overvaluation caused the sharp decline in small cap stocks from March to May. In my opinion, that was the first warning shot.

The other big buyers of U.S. stocks, Sovereign Wealth Funds, could disappear quickly when global economic conditions worsen. The buyers could quickly become sellers. It’s something I watch carefully.

Conclusion: When valuations go to extremes, and financial engineering is the main propelling force for the rise in the big cap stock indices, I look at technical indicators that tell me what the majority of stocks are doing, not just the major indices.

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